LESSON 12- INFLATION

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    Main Lecture:

     

     

    1.What is Inflation?

     

    Inflation refers to a general and sustained rise in the level of prices of goods and services. That is, prices of the vast majority of goods and services on sale to consumers just keep on rising and rising! Prices change over time so inflation is always given per period of time – per month or per year. For example the inflation rate in Pakistan in 2009-2010 was 10.15 % . That is, on average the prices of all goods and services rose by 10.15 paisa in every rupee over that year.

     

     

    1. How does the government calculate Inflation?

     

    An index of consumer prices, the retail price index (RPI), shows the change in the general price level in percentage terms over time. It seeks to calculate, the changes in the price of a very large ‘shopping basket’ of the products bought by consumers. There are a number of stages in constructing a price index. Firstly, a base year has to be selected. Government statisticians try to select a relatively standard base year in which there were no dramatic changes, in other years are compared to this figure. Then, the spending patterns of house holds are observed by carrying out surveys of house hold expenditure from a sample of representative house holds. From the information obtained, the main commodities being bought by households are identified and weights are assigned to each commodity which reflect the proportion of expenditure on that commodity. Each month government officials find out information about prices of these commodities and estimate the change in prices. Having assigned weights to different items included in the index and measured price for each category, and then sum up the weighted index of each category to obtain the Retail Price Index.

     

     

    For Example

     

    Commodity Weights x Price Index = Weighted Price Index
    Food 0.4 x 130 = 52
    Housing 0.1 x 120 = 12
    Transport 0.3 x 105 = 31.5
    Entertainment 0.2 x 90 = 18
      1.0       RPI = 113.5

     

     

     

    Hence using data from the above table, it can be said that relative to the base year, prices have increased by 13.5% (113.5 – 100)

     

     

    1. Causes of Inflation

     

    (i) Government policies:

     

    Some economists argue that governments only have themselves to blame for the high inflation rates. This is because some governments try to boost demand to reduce unemployment in the economy in periods when labour unemployment is high and rising. For a time the increase in demand will reduce unemployment as firms take on more resources to produce more goods and services. However, inflation soon begins to rise as aggregate demand increases faster than output. Eventually the high inflation reduces the purchasing power of people’s incomes and demand for goods and services begins to rise.

     

    The government also aims for economic growth. However, it is a known fact that economic growth also results in inflation.

     

    (ii) Demand-pull Inflation:

     

    Inflation caused by an increase in aggregate demand is called demand-pull inflation. Aggregate demand in an economy will rise if spending by governments, consumers and/or firms increases. Consumers will be able to spend more of their incomes if they reduce saving or if a government cuts income taxes. An increase in aggregate demand will cause prices to increase and inflation to rise if firms are unable to increase supply of goods and services at the same rate.

     

    (iii) Cost-push Inflation

     

    Inflation caused by higher costs feeding into higher prices is called cost-push inflation. The cost of producing goods and services can rise because workers demand increases in wages or cost of raw material rises etc. Firms may pass these higher costs on to consumers as higher prices so that they do not have to suffer a cut in their profits. A rise in costs is likely to cause a fall in supply. As supply falls, prices will rise (keeping other factors constant).

     

    (iv) Imported Inflation

     

    Many materials and finished goods and services are imported from overseas. An increase in their prices will also boost inflation in Pakistan. This imported inflation can occur if the value of the Pakistani Rupees falls against foreign currencies like the US dollar or Euro. As the value of Rs falls the price paid for imported products will rise even if the prices of those goods in US dollars, Euros or other foreign currencies have not changed. The reverse is also true: if the value of the Rs rises the price paid for imported products will fall.

     

     

    1. Costs of Inflation:-

     

    (i) Personal Costs

     

    Rising prices reduce the purchasing power of people’s incomes. That is, their real income, in terms of what it can buy, falls. For example pensioners and students who are on fixed incomes decided by the Government, face a stern challenge by the rising prices while their incomes remain stagnant. Thus their purchasing power falls. However professional people and workers in strong trade unions may be able to ask for wage and salary increases. For them, inflation wouldn’t hurt that much!

     

    People who save or lend money may also be hurt by inflation. If they find the interest rate received on money they have saved or lent is lower than the inflation rate the real value of their money will fall. They will be worse off. On the other hand, people who borrow money will benefit by repaying less in real terms than they borrowed.

     

    (ii) Cost to the society

     

    Some economists argue that inflation causes unemployment. As prices rises, people cannot afford to buy so many goods and services and so demand falls. In addition, some people save more in times of high inflation to protect the real value of their savings. This again means less spending on goods and services. As a result firms may cut their output and make resources, including labour, unemployed.

     

    If the Pak rate of inflation is higher than the rate of price inflation in other countries it becomes more and more difficult for Pak firms to sell their increasingly expensive goods and services abroad. In addition, Pak consumers may increase their spending on cheaper imports and buy fewer domestic products.

     

     

     

    QUESTION/ANSWERS SESSION

     

    Q1. How might inflation affect a person’s spending, saving and borrowing? [10]

     

    Ans. Inflation erodes the value of money reducing the purchasing power of consumers. This implies that a person needs to spend more in nominal terms to consume the same amount of goods and services, for instance, if a pair of jeans costed Rs.500 in year 1. At an annual average rate of inflation of, say 10%, the person would have to spend Rs.550 to buy the same pair of jeans in year 2. So inflation might increase a person’s spending, at least in money terms. However, as goods and services become expensive due to inflation, quantity demanded is likely to fall, according to the law of demand. Thus, with unchanged money income levels, a person’s real spending might fall, but his basic necessities before he decides to save a part of his income. As real incomes decline due to inflation, savings are likely to fall. This is because money saved today will have less purchasing power in the future so a person might prefer to spend today to avoid the loss of purchasing power in the future. However , it depends on the purpose of saving and the expected rate of future inflation. Unlike savings, inflation might increase a person’s borrowing. This is because  the person would have to repay less than the borrowed amount in real terms, as money would lose value over time so borrowers are likely to gain during a period of inflation. Also, increased borrowing may be required to maintain current spending, if money incomes do not increase in line with the rate of inflation. However, the effect on a particular person will depend on that person’s particular circumstances, the prevailing rate of inflation, and the person’s expectations regarding future incomes and prices.